The conventional wisdom of a 1929 stock market bubble is challenged by a long-term view. Even investors who bought at the peak saw a 6% real return by 1959, suggesting the so-called speculators were correct about America's future growth, just extremely early.
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The Shiller P/E ratio, a measure of long-term market valuation, has only crossed 40 three times: 1929, 1999, and today. The first two instances preceded major market crashes (The Great Depression, Dot-com Bust) and were followed by a decade or more of flat or negative real returns for investors.
Contrary to popular belief, earnings growth has a very low correlation with decadal stock returns. The primary driver is the change in the valuation multiple (e.g., P/E ratio expansion or contraction). The correlation between 10-year real returns and 10-year valuation changes is a staggering 0.9, while it is tiny for earnings growth.
The 1920s bubble was uniquely driven by the new concept of retail leverage. Financial institutions transported the nascent idea of buying cars on credit to the stock market, allowing individuals to buy stocks with as little as 10% down, creating unprecedented and fragile speculation.
Contrary to popular belief, the 1929 crash wasn't an instantaneous event. It took a full year for public confidence to erode and for the new reality to set in. This illustrates that markets can absorb financial shocks, but they cannot withstand a sustained, spiraling loss of confidence.
A market enters a bubble when its price, in real terms, exceeds its long-term trend by two standard deviations. Historically, this signals a period of further gains, but these "in-bubble" profits are almost always given back in the subsequent crash, making it a predictable trap.
The S&P 500's high concentration in 10 stocks is historically rare, seen only during the 'Nifty Fifty' and dot-com bubbles. In both prior cases, investors who bought at the peak waited 15 years to break even, highlighting the significant 'dead capital' risk in today's market.
Michael Mauboussin argues the market is inherently long-term oriented. For major Dow Jones stocks, nearly 90% of their equity value is derived from expected cash flows beyond the next five years, debunking the common narrative of market short-sightedness and a focus on quarterly results.
While being a market Cassandra can build a reputation, being too early is costly. Charles Merrill of Merrill Lynch famously warned of a crash in 1928, but investors who heeded his advice missed a 90% market run-up before the October 1929 peak, illustrating the immense financial downside of exiting a bubble prematurely.
The stock market is not overvalued based on historical metrics; it's a forward-looking mechanism pricing in massive future productivity gains from AI and deregulation. Investors are betting on a fundamentally more efficient economy, justifying valuations that seem detached from today's reality.
The narrative of the 1929 crash as mass psychological panic is misleading. The primary driver was a mechanical liquidity crisis where heavily leveraged investors were forced by margin calls to sell, creating a downward spiral regardless of their long-term belief in the market.